On money

'W' spells out more trouble for economy

Combination of inflation, slowing growth points to downward trend

August 05, 2008|By Gail MarksJarvis

Call it the "W" economy -- but that doesn't stand for "winning."

It could stand for "wincing," or the Federal Reserve's reaction as it holds an important meeting Tuesday to confront a nasty combination of inflation and slowing economic growth at a time when consumers are hurting.

In fact, the "W" is how some experts describe the unpleasant shape of the economy.

Imagine writing the letter "W": Your first stroke down is the route the economy was on until tax rebates stimulated consumer spending and provided an upswing.

The next move, however, is expected to be an unpleasant slope downward.

"In the fourth quarter, we expect a 1.5 percent decline in real consumption, holding GDP flat," said Goldman Sachs economist Jan Hatzius. "The economy is likely to remain stagnant in the first quarter of 2009."

That means more danger that people will lose jobs.

The unemployment rate has been climbing and is now at 5.7 percent. Merrill Lynch economist David Rosenberg said that with businesses facing higher costs at the same time of sluggish demand, "businesses are going to be forced to step up their layoffs to protect their margins. Employment-search firms already see this coming because temp agency jobs were cut 29,000 in July, and this came on top of an 88,000 slice in the prior three months."

Of course, at some point the final upswing in the "W" will occur as the economy mends. BlackRock co-head of fixed income, Peter Fisher says that point might be a year away.

But now economists say the forces pulling at the economy are still in their early stages. Monday the Commerce Department released disappointing numbers on personal income and spending. Even with rebates, consumer spending increased by 0.6 percent in June and personal income was up a mere 0.1 percent, while prices rose 0.8 percent, the most since September 2005.

"When you look at real consumer spending net of medical care, food and utilities, what you see is that it contracted 0.3 percent at an annual rate in both the fourth quarter of 2007 and first quarter of 2008," said Rosenberg. "This has never happened before outside of classic recessions."

Economists believe the weak conditions will push the Federal Reserve into deliberate inaction at the end of Tuesday's meeting. Experts expect the central bank to hold the benchmark for interest rates at the current 2 percent. While the Fed might want to raise rates to try to tame the inflationary pressures that are tugging at both household and corporate budgets, economists say the greater threat now is a slowing economy and a weakening consumer.

Despite the gloomy attitude consumers have shown in surveys, Fisher says Americans have not begun to digest the financial constraints that will eventually hold them back from spending.

"People aren't always borrowing money," and they will discover the impact of the credit crunch when they do, he said. "Perhaps it's when they try to take out a student loan, or a home equity loan to pay for college."

Fisher says it will take a long time for the credit crunch to ease because lenders will feel the impact of "mortgage assets decaying."

Hatzius is predicting housing prices will decline another 10 percent as lenders remain reluctant to provide mortgage loans. But it's not just mortgages that will remain less available.

"Auto credit is now under pressure," he said. "Concerns about the consumer outlook will probably lead to further tightening in credit card and other household lending."

As food and energy prices stay high, he expects "discretionary cash flow for the household sector will actually shrink over the remainder of 2008, making an outright contraction in consumer spending likely."

The pressures will also spill over into other parts of the economy.

With shrinking home values, job losses and fewer purchases, property, income and sales tax receipts will decline, said Hatzius. Governments consequently will need to rein in spending, perhaps resulting in government job losses and fewer purchases from businesses.

Meanwhile, the savior for the U.S. economy -- the ability of companies to export massive quantities of goods abroad -- is losing its power. Worldwide the combination of slowing U.S. growth, a weak U.S. dollar and inflation is tugging on economies and stifling purchases.

Until recently, the world has been eager to gobble U.S. products. U.S. exports provided "a whopping 2.4 percentage points of real GDP growth" in the second quarter, said Hatzius. Yet, in 2009, Hatzius estimates U.S. exports will average only about 1 percentage point of U.S. GDP growth.

"Global economic signals have turned sharply weaker," noted Hatzius. "Although the weak dollar should continue to help U.S. exporters gain market share, the risk that foreign demand weakness will wash back onto U.S. shores is clearly growing."

Of course, as the world slows, inflationary pressures related to energy and commodities could subside somewhat, too, easing one of the current burdens on consumers and businesses.

Oil on Monday settled at a three-month low of $121.41 a barrel.

"One cushion that is falling into place is the decline in energy prices," said JPMorgan economist Bruce Kasman. "It is premature to gauge how low prices might go, but the gravitational pull of weakening global energy consumption now looks firmly established."

Kasman says that if oil moves to $100 a barrel -- as some oil analysts are predicting -- by the end of the year, that could drop U.S. inflation below 2 percent. And that would boost purchasing power across the globe.

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What's next

The meeting: The Federal Open Market Committee of the Federal Reserve meets Tuesday to assess the economy.

The decision: Worried about inflation but hemmed in by slow growth, the Fed is likely to keep its target for the federal funds rate at 2percent.

The outlook: Economists see rough times ahead, with more job losses, and some experts predicting no recovery for a year.